How to Calculate Effective Cost

Effective cost shows how much a firm paid per unit during the year.

Effective cost is similar to average cost. Usually when a company buys a product from another company over the course of the year, the price normally changes. The effective cost is the cost that applies to the product for the entire year. This is a similar concept to the effective tax rate, where tax rates change based on income. An effective tax rate gives the rate the company paid during the year. It is important to keep this in mind when calculating effective costs.

Instructions

1. Determine the total number of units the company bought during the year. For example, Firm A bought 50,000 units.

2. Determine the total spent on the unit during the year. For example, Firm A bought 25,00 units for $3, 10,000 units for $4 and 15,000 units for $3.50. Multiply $25,000 by $3, which is $75,000, then 10,000 units by $4, which equals $40,000 and 15,000 units times $3.50, which equals $52,500. Add the costs, so $75,000 plus $40,000 plus $52,500 equals $167,500.

3. Divide the total cost by the total number of units to determine effective cost. In our example, $167,500 divided by 50,000 units equals $3.35.

References

• University of South Carolina: Average Cost
• Investopedia: Effective Annual Interest Rate